If you’re like most Americans who built their retirement savings through decades of earning and saving, you’re probably most familiar with the fact that money you earn, either doing a job for an employer or working for yourself as a business owner, is taxed according to the marginal tax brackets that expand slightly each year with inflation, while occasionally changing rates with tax law changes.
However, once you shift from working for a living to living off your savings, the way the money you pull from your various accounts may shift. It’s quite common for first-year retirees to be caught with a surprise tax bill due to this change, which may or may not require a change in how you plan and pay your taxes throughout the year.
Let’s go over the most common sources of income in retirement, and dive into how each is taxed, in plain English, of course.
Also note that this post is specific to federal income taxes as several states have different tax rules for retirement income or no income taxes at all. For more on that, check out this Kiplinger article.
Ordinary income
What you’re most used to as a working person, ordinary income is taxed according to the marginal tax brackets, or to generally summarize, it’s money that’s taxed as if you earned it at the time you received it. The following income is taxed as “ordinary,” even in retirement:
Distributions from traditional retirement accounts. Sometimes referred to as “pre-tax,” traditional retirement accounts include IRAs, 401(k)s and inherited retirement accounts. Note that the label “traditional” is what will make this taxable (vs. Roth).
Pension benefits. Whether taken as a lump sum or annuitized into regular payments over your lifetime, pension benefits are taxed when you receive them.
Social Security. Perhaps most surprising is the fact that Social Security payments MAY be taxable, depending on your total income. To figure out how much, if any, of your benefit may be taxed, refer to this calculator. The good news is that even if your SS benefit is considered “fully” taxable, you only have to include 85% of what you received in your income. In other words, if you received $10,000 in benefits, the most you’d have to include as income would be $8,500.
Part-time work. Just like full-time work, you’ll have to pay taxes on any part-time income.
Tax-deferred annuities. Depending on the type of annuity you purchased, you’ll pay ordinary income taxes on either the full amount you received that year if it’s a qualified annuity, or you’ll only have to include any earnings you receive if it’s a non-qualified contract.
REITs. Any dividends you receive from real estate investment trust assets you hold in a non-retirement account will be taxed as ordinary income, unless it’s classified as a qualified dividend (see below for more on that).
Interest and ‘ordinary’ dividends. Most dividends these days are considered qualified, but not all. In this case they are called ordinary and are included along with any interest received from bank accounts, corporate bonds or other investments that pay taxable interest.
Rental income. While you’ll likely have deductions to offset rental income, any net income will be taxed at ordinary income tax rates, with losses carried forward to future years.
Non-qualified distributions. If you take a distribution from a Roth, 529 college savings plan or Health Savings Account that is considered “non-qualified,” meaning it’s NOT in accordance with the distribution rules, then it will be subjected to ordinary income tax and in some cases, a penalty may also apply.
Capital gains
Capital gains taxes are considered to be preferential rates, which can be a key consideration in building a tax-efficient retirement income plan. The following sources are subjected to capital gains taxes. Note that assets held in retirement accounts do NOT get this treatment and instead are either taxed as ordinary income (as per above) or exempt from tax (as per below).
Stocks, bonds, mutual funds and other investment securities. As long as you hold a security for one full year before selling it, any profit, or gain, on the sale is taxed at long-term capital gains tax rates, which are always going to be lower than your marginal ordinary income tax rate. Short-term, or assets held for less than a year, are included as ordinary income. Any losses can be deducted against gains with up to $3,000 of net losses applied against your other income. Any losses in excess of $3,000 in a particular tax year are carried forward to the next year to offset gains and income the following year.
Qualified dividends. Most dividends received from publicly traded stocks are classified as qualified and subjected to the lower long-term capital gains tax rates. Again, this only applies to assets held outside retirement accounts, such as in a taxable brokerage.
Real estate, with exceptions for your primary residence. Any time you sell real estate for more than you paid, you’ll need to calculate the gain, which is why it’s important to keep track of any improvements made to the property while you own it. This is especially important if you’ve lived in your primary residence for many years and are selling it for significantly more than you purchased it. Married filing jointly can exclude up to $500,000 in capital gains on the sale of their primary home ($250,000 for single tax filers), while the sale of any other real estate, such as a vacation home or rental property will have all appreciation in value taxed as capital gains in the year of the sale.
Cryptocurrency. Bitcoin, NFTs and other crypto assets are taxed the same as stocks when sold for a gain or loss.
Art, vehicles, coins, jewelry, etc. Any collectible sold at a gain and held for more than a year are taxed at a higher 28% tax rate. Note that this doesn’t apply to any personal use vehicles, which don’t qualify for any type of tax treatment.
Tax-free
There are several asset classes that can provide tax-free income, as follows.
Roth accounts. Whether held in an IRA, 401(k) or 403(b), distributions from accounts designated as Roth type are not taxed when received as long as you’re at least age 59 ½ AND you’ve had a Roth account open for at least 5 years prior to the distribution (with limited exceptions). The same is true for any Roth accounts you inherit, as long as the person who left you the account had it for at least 5 years (although special distribution rules apply to inherited retirement accounts).
Municipal bonds. You generally don’t have to pay federal taxes on any interest received from government and other municipal bonds, although this type of interest does come into play when calculating the taxability of your Social Security income and other calculations that use Modified Adjusted Gross Income as a benchmark.
Health Savings Accounts (HSA). Quite possibly the most powerful retirement asset out there, any distributions from your HSA to pay current or past reimbursed qualified medical expenses are tax-free. Note that you have to have had an HSA at the time a prior expense was incurred, but there is no time limit on going back in time to pay yourself back for expenses you paid but didn’t use your HSA for back in the day. Distributions from your HSA for NON-medical expenses is taxable, but once you’re 65, you won’t pay the 20% penalty, in case you have a large balance but no expenses to make qualified distributions.
Inherited assets outside retirement accounts. While you may not be able to sell inherited capital assets totally tax-free, these assets get what’s called a step-up in basis upon the death of the original holder, so if you sell something you inherited pretty quickly after receiving it, you’ll likely have limited capital gains taxes, if any.
As you can see, the US tax code is anything but simple, but understanding that different sources of income may come with different tax rules can help you to do some tax planning in retirement to minimize your lifetime tax bill. It may also help you to better understand why your tax situation changes when you shift from most of your income coming from a job or earnings to different sources with different tax rules. Depending on your situation, this may be a good thing or it could be a bit painful if you find yourself owing when you’re used to receiving a refund.
For more help understanding how your retirement income might be taxed or to build a tax-efficient retirement income plan, let us know. This is a key way that we help our retired clients enjoy a stress-free (and ideally lower-tax) retirement.
Disclaimer: This article is intended for informational purposes only and is not an exhaustive review of all ways that your income could be taxed, nor should it be used as tax, legal or investment advice. For a personalized assessment of your tax picture, work with a qualified professional.